Don’t Like Austerity? Try 'Financial Repression'

Indebted governments will have to find ways of "rigging the financial system to suit themselves," because there is no decent economic growth in the West, and there aren't coherent fiscal consolidation plans to help governments bring down budget deficits, according to HSBC Chief Economist Stephen King.

"Financial repression results from policies which allow governments to fund their borrowing through imposing costs on others," King wrote in a market note.

Governments could use regulations to force banks to lend more to the government while liquidity-pumping policies – such as quantitative easing– push bond yields down even when fiscal policy is out of control, allowing governments to avoid being punished by markets for lack of fiscal discipline, he explained.

The 1950s and the 1960s were, for the Western world, a period when financial repression seemed to work, as government debt fell rapidly. "This, however, was more a happy coincidence: debt fell rapidly for other reasons, allowing economies to shrug off the effects of repression," King wrote.

If applied today, repression is likely to starve the private sector of funds, as the rapid reduction in debt seen in the '50s and '60s was a consequence of bumper growth which brought in tax money rather than of government borrowing crowding out the private sector, he warned.

A Way to Live With Debt

King noted that real interest rates are much lower today than they were 10 or 20 years ago but, despite their decline, debt levels have soared, both because of the financial crisis but also because of a structural slowdown in economic growth.

"Repression may well redistribute the burden of adjustment from debtors to creditors via unusually low real interest rates but, in itself, is unlikely to be enough to deliver a major reduction in government debt as a share of GDP," he said.

However, even if governments know that their debts will not be reduced by repression, it does not mean they will not use it, King warned.

In the euro zone, electorates have made their dislike of austerity clear, with the Dutch government the latest victim of attempts to rein in the budget deficit by cutting spending.

In France, Nicolas Sarkozy is fighting forre-election in early May after he came in second in the first round of the vote, with voters clearly unimpressed by the prospect of austerity, while after Greece defaulted on its debt, elections in that country are likely to be a wild card for markets.

"A government unable to reduce its debt will be on the lookout for cheap ways to fund its profligacy. Financial repression is one way of doing so," King noted. "Repression allows governments to delay austerity and to fund excessive borrowing at very low cost: It is, then, a useful way to force the rest of the economy to make room for government excess."

"Seen this way, repression is not so much a mechanism designed to reduce government debt but, rather, a way to live with it," he said.